Wednesday, May 22, 2013

A description of the moneyness market

Imagine a market where buyers and sellers of moneyness congregate. In this post I'll flesh this market out.

By moneyness I mean the extra bit of value, or premium, ascribed to some good or asset because of its exchangeability. Assets that are more exchangeable, or liquid, will have a larger premium attached to them. Less liquid assets will have little to no premium.

Put more explicitly, let's say that Microsoft issues two types of shares, MSFT.A and MSFT.B. Both are entirely alike. They have the same dividend, carry the same voting rights, and are ranked equally in terms of seniority. The only difference is that MSFT.B shares are more exchangeable. Let's say that while MSFT.B can be sold whenever the owner wishes, MSFT.A can only be sold by their owner after one year has passed. A moneyness premium should emerge as the price of B shares trade above the price of A shares. Because the shares are entirely similar, this divergence can only be a product of B's superior liquidity services, a feature that investors willingly pay a premium to enjoy.

In our simple MSFT market, a buyer of moneyness prefers to pay up for higher priced MSFT.B in order to enjoy B shares superior liquidity. A seller of moneyness will trade away MSFT.B in order to purchase lower cost MSFT.A and bear the inferior liquidity of A shares.

We're more interested in a complex moneyness market that allows us to price the relative moneyness of all financial assets, not just MSFT.A and B.

We can start by establishing a centralized market. A seller of moneyness deposits their financial asset at an exchange, or clearinghouse, for a set period of time, say one year. In depositing their shares or bonds for a fixed term, the owner loses their right to transact in that asset over that time period. But they continue to enjoy all other rights associated with ownership, including dividends, interest, capital gains (or losses), and voting.

Interposing an exchange or clearinghouse between buyers and sellers of moneyness solves for credit risk. In futures markets, for instance, counterparties face no unique counterparty risk since the exchange promises that either side will be made whole should the other side default. Futures exchanges use performance bonds, or margin, to ensure that they can always meet their obligations. A moneyness market could also work along these lines.

Buyers of moneyness bid for the use of assets deposited at the exchange by sellers. Buyers have no right to any dividends, interest, or votes over that time period. But they earn the right to use that asset as a pure transactions asset. Buyers can repo it for cash, sell it, rent it out, use it as collateral, or mobilize it to settle trades. The range of transactions they can engage in is the same range of transactions that the seller of moneyness has chosen to forgo by depositing their asset for a fixed term.

At the end of the term, the moneyness buyer must return the deposited asset back to the seller. The price that competing buyers pay competing sellers in order to enjoy this range of transactional services over the fixed term of the deposit must be enough to compensate the seller for waiving these transaction opportunities. The price that these parties negotiate is equivalent to an asset's moneyness.

The exchange or clearinghouse might offer a range of fixed term deposits, say 1, 2, 3, 5, and 10 years, for various financial assets. A moneyness curve would develop, allowing investors to make intertemporal liquidity comparisons across the same asset. For instance, in order to maximize returns would it be better to deposit MSFT for a two-year fixed term, or roll over two successive one year terms? This sort of question can be answered by looking at an asset's moneyness curve.

Establishing a market like this would also allow investors to make liquidity comparisons across different assets. For instance, a long term buy and hold investor might be able to deposit MSFT for five years and earn 0.15% a year for their troubles, but if they deposit GOOG for five years, they'll earn 0.20%. This will affect their initial purchasing decision, since buying GOOG and depositing it for five years will provide a greater return than buying and depositing MSFT.

Those assets that offer the highest deposit rates over a given time period will typically be the most liquid assets. After all, investors will require the greatest amount of compensation for forgoing the transactions services thrown off by assets with superior liquidity. Conversely, those assets that offer the lowest deposit rates will typically be the least liquid, since investors require little to no compensation for surrendering the stunted range of transactions services provided by illiquid assets.

Just like credit default swaps allow a bond owner to sell off the default risk to another investor, our centralized moneyness market would allow investors to sell away an asset's moneyness to someone else while keeping the real return component of an asset. Some possible economy-wide benefits this mechanism might provide:

1. A moneyness market allows for a better allocation of liquidity amongst market participants. Those who don't need moneyness can sell it off while retaining the rights to the underlying asset. Those who want extra moneyness can purchase this quality without having to buy the entire asset.

2. By putting a price on liquidity, isolated pools of liquidity can be tempted back into the broader market in order to smooth out liquidity shocks.

3. Right now, getting information about the liquidity or illiquidity of various assets is difficult. A moneyness market allows us to build a precise market-based ranking of all assets, from stocks to bonds and debentures, to commercial paper, paper dollars, and mortgage backed securities, according to their relative moneyness. Information is usually a good thing.

6 comments:

What about using B shares shares as an adjunct medium of redemption/settlement (in addition to gold, for example) in a Free Banking system?

In "The Theory of Monetary Institutions," Lawrence White asks, "Why don't banks settle with other financial assets [besides base money]?" (p. 244) He concludes that using something like IBM shares encounters a "bid-ask spread problem" of how to value the shares at the moment of clearing. But surely, banks are clever enough to devise some protocol for handling this issue, right?

I like parts of the Greenfield-Yeager proposal for separating the medium of account (commodity bundles in which bank-issued money is denominated) from the medium of redemption. So a Free Banking "dollar" could be defined as a commodity basket which could be redeemed in a more convenient medium of equal value (such as gold, or perhaps financial assets such as B shares).

I think a crucial point to appreciate about stocks is that simply having a price that is bobbing up and down in a random way can be harvested as a stream of revenue. If the price is more or less stable, then that means that every 20% drop is matched by a 25% gain (4/5 x 5/4 =1), every 50% drop is matched by a 100% gain (1/2 x 2 =1)etc. A 50% drop from $100 is $50 but a 100% gain from $100 is $100. Simply re-balancing (eg against a holding of long term treasuries or whatever) will harvest that volatility. Share buy back activity by firms occurs predominately at price peaks. In that way earnings are used to drive volatility and that volatility harvesting comprises a major way that profits are distributed to share holders (though obviously they pass by index fund holders).Liquidity causes such harvesting to have lower transaction costs. It becomes possible to harvest volatility on a second by second basis.

I think the buyers of these instruments need to really be fleshed out for me to understand the market better, I'm not exactly sure what they'd be buying. Does the liquidity part mean they are essentially just trading the ticker price over the course of time that the financial asset is deposited at the exchange?